The ghosts of Lehman Brothers and Bear Stearns returned late in this year in the guise of MF Global’s bankruptcy filing and a precipitous drop in Jefferies’ stock prices.  While these two may turn out to have little in common, from the perspective of investment fund managers to whom these institutions serve as prime brokers or custodians and, to a lesser extent, clearing brokers, the message is clear.  The risk of having your funds’ assets tied up for prolonged periods of time in a bankruptcy or some other insolvency process is quite real (as is a possible risk of loss of such assets to the extent they have become the subject of third parties’ security claims or simply have been misappropriated by your counterparty).  

Hedge funds have been on notice at least since 2008 that the text of the prime brokerage agreements they enter into can have momentous significance when things begin to go very wrong with their prime brokers (whether because they get caught up in a tidal wave of a financial crisis or for more localized reasons of financial mismanagement).  The failure of MF Global, in particular, has highlighted loopholes in the Australian regulatory system which allowed it to use client funds to hedge its own positions with full consent of the Australian regulator.  Whereas in the United Kingdom, we understand it is illegal to use clients’ money for any of the provider’s own activities, including hedging, the Australian OTC derivatives rules prevent brokers from using client funds to trade on their own account but allow trades with clients’ funds to hedge positions.  This includes margining, guaranteeing, securing, transferring, adjusting or settling dealings in derivatives by the licensee, including hedging positions taken by other clients.  As a result, the Australian government may be unable to take action if investors’ funds have been pooled together by MF Global and used for hedging purposes. 

Some of the same lessons of the Lehman bankruptcy apply today.  We advise our fund clients to negotiate their prime brokerage agreements carefully, especially with respect to the prime broker’s re-hypothecation rights and rights to transfer client assets to affiliates and sub-contractors.  Prime broker’s recourse against funds’ assets should be limited (preferably to those assets posted as collateral against loans in margin accounts) rather than left as blanket authority.  What has now emerged from the MF Global scandal underscores the necessity to restrict the powers of prime brokers to make use of the clients’ collateral as much as possible in order to prevent funds’ assets from being used in the prime broker’s own proprietary transactions and from being transferred out of the U.S. jurisdiction. 

Some of our clients have conducted a review of the insolvency laws in the major jurisdictions where their prime brokers are located to understand better the legal treatment of the funds’ assets in the event of the prime broker’s bankruptcy and to adjust the mix of their assets held by prime brokers accordingly.  The counterparty’s insolvency risk can also be managed through master netting arrangements to reduce the clients’ exposure although their enforceability varies from one jurisdiction to another.  In some situations, it may be prudent to request a special, segregated treatment of the client’s assets by having them held by a third party custodian and/or to request registration of the client’s securities in the fund’s name rather than in “street” name, though counterparties are reluctant to agree to such arrangement. 

We also advise our clients to negotiate the “boilerplate” clauses with vigilance to the extent they relate to the issues we highlighted above, including in the assignment clauses where we insist that any such assignments be limited to the prime broker’s affiliates that are licensed U.S. broker/dealers.  Once the funds leave the U.S., foreign laws and regulations make their well-being in the hands of foreign affiliates of the U.S. prime broker somewhat uncertain, as this latest case with MF Global amply demonstrates.  The protections of the U.S. regulatory regime do not normally extend to non-U.S. affiliates of U.S. prime brokers, and such entities are often utilized for margin or securities lending and as custodians outside of the U.S.

We realize that in the last few years the prime brokerage industry has become the game of a few, largest (though not necessarily strongest) financial institutions who resist vehemently any changes to their form agreements (which, incidentally, underwent few changes since 2008 to reflect the new realities of the marketplace).  Prudent risk management practices dictate that fund managers as fiduciaries avoid selecting weaker prime brokers, and so their business has been flowing to the few strongest banks with the healthiest balance sheets and reserves, resulting in the ever-growing obstinacy on their part to negotiate terms of their prime brokerage agreements characteristic of any oligopoly. 

However, it is incumbent on the fund manager to request reasonable assurances with respect to their managed assets when negotiating with these banks because any bank, no matter how big and strong today, may end up insolvent tomorrow.  In fact, accepting their standard forms without negotiation is not, in our opinion, the best practice to follow for investment managers.  And, to the extent a fund manager elects to deal with those smaller banks and brokers that lack market power, it ought to extract even greater legal protection for its investors’ assets from such counterparties to compensate for the higher risk of insolvency.  Gone are the days when default, cross-default and cross-acceleration provisions are thought to apply only to clients of banks.  Today, it is vital that as many of those be made mutual as possible.  Finally, in anticipation of a bank or broker succumbing to a potential crisis it is useful to include prime broker’s cooperation clauses to help transition to a different bank and to move the funds’ assets promptly that would be triggered by the client’s request (based on some early warning sign) rather than waiting for the prime broker’s default to occur before taking action.

Needless to say, prime brokerage agreements are not the only ones where counterparty risk of the service provider has to be addressed through contractual protections.  Agreements for any custodial arrangement, fund administration, collateralized borrowing (where the funds’ assets are the subject of a security interest) and even certain trading activities (such as under the ISDA regime with respect to swaps and derivatives) should be scrutinized to provide for the adequate contractual mechanisms to minimize counterparty risk.  Further, counterparty risk in dealing with third parties as principals rather than service providers can be extraordinarily high in certain transactions, such as participation agreements, contracts for difference and repurchase agreements (more on these in our future blog postings).  The economic risk with respect to any single transaction, however, tends to be significantly smaller than in typical global prime brokerage and custodial relationships where most, if not all, of managed assets may be placed so these should naturally be the priority in getting counsel to review and to help negotiate the appropriate safeguards. 

As counsel to hedge funds and private equity funds, we have helped many of our clients achieve a greater sense of security with respect to the assets they manage in the hands of prime brokers, fund administrators and custodial agents and other service providers to the private investment fund industry.